By Lior Alkalay, eToro Senior Analyst
It was little more than a year ago, a Friday, March 11th, a black day that can never be forgotten; a day when the entire world sat, transfixed by scenes so devastating that even Hollywood’s most creative couldn’t have imagined them. To a one, we can almost instantly, and with perfect, agonizing recollection, envision the scenes of terrified Japanese trying to flee the ominous huge black wave, created in the aftermath of a major earthquake, as it flooded their shores. The destruction was horrific; more than 9,000 deaths, 2,000 missing and 4.4 million people left homeless. As if the tsunami wasn’t enough, the flooding which followed ignited a nuclear disaster in the Fukushima compound. The radiation contaminated the entire Fukushima area, transforming entire cities and villages into “ghost towns,” while simultaneously destroying wide swaths of agriculture in the north east of Japan. And despite the death, destruction and shock to not just their homeland but their collective psyche, the Japanese people never lost their spirit, or their hope. No, throughout the ordeal they prevailed, and they did so with incredible, awe-inspiring dignity, calm, resolve and perseverance.
However, death and destruction were not the only damage; the earthquake and tsunami had a massive economic cost, as well. Estimated damage from the tsunami and radiation from the damaged nuclear plants are estimated to be more than $180 billion. And that estimate is only the direct effect, not taking into consideration secondary effects of loss of jobs, and the potential economic costs of lost agrarian lands and other long term damage as a result of the flooding and radiation. And while the world bore witness to the noble spirit of the Japanese people who valiantly withstood the after-effects of the disaster, the economic community, which had witnessed the Japanese economy sinking and drifting lower for much of the last 20 years, believed that this would be the last straw, that this – the latest and greatest damage – would finally eclipse Japan, the land of the rising sun. In that belief, they would be proved wrong.
The curse of the Yen
Most investors and not a few analysts had estimated that 2011 would be a difficult one for Japan, with a serious economic downturn as a large proportion of Japanese industry had been paralyzed for a prolonged period of time; Barclays Bank estimated the damage to be as much as 3% of GDP. But the Japanese economy, very much like the Japanese character, endured and was on the path to recovery. Eventually, despite the devastation, there was a remarkable rebound in Japanese business activity with GDP for 2011 contracting by only -0.47%, a great and welcome surprise to most economists. And this is even as Japan was forced to shift away from nuclear energy, and suffered with increased energy costs.
Of course, economists continue to downgrade their expectations of Japanese growth, pointing to the fact that Japan was already at the end of two “lost” decades of dismal growth and tends to suffer from chronic deflation that has been worsened by the strengthening Yen which heavily weighs on exports.
If there were one key characteristic which could be considered the real drag on the Japanese economy over the past two decades, it would certainly be the strength of the Japanese currency. Although the economic devastation of the natural disasters are enormous, it is in the strong Yen that has continued to weigh so heavily on the Japanese economy, to the point that it has become practically numb, drifting and slowly sinking.
Japan is an export-oriented country with the total of all exports valued at $800 billion (2011 figures) and so, like all exporting countries including China and Brazil, a higher valued currency is significantly hurting exporters’ profits. Since the 1990s, the Yen has appreciated considerably, rising more than 50% in relation to the U.S. Dollar’s value. An aggressive appreciation by all means, but even more so when you consider that Japan is not an emergent economy like China, where workers earn a few hundred dollars a month, but a fully developed, modern economy with average wages that are among the highest in the world. A 50% rise in the Yen’s value, therefore, means that Japanese manufacturing costs had spiked quickly. It is only recently that we have begun to bear witness to the severe effects on Japanese exporters; Sony, the electronics giant, announced that it was letting go some 10,000 workers, equivalent to 6% of its workforce, and Toyota, the automotive behemoth, estimated the impact of a strong Yen on its operational profit to be ¥250 billion.
The vicious cycle
The Japanese unit labor cost (effectively, a calculation of workers) is so high that Japan is suffering a wave of falling wages and, as consequence, falling prices. When prices fall, citizens prefer to save rather than spend and if the inflation rate is negative, even a bond yielding zero is actually positive, right? This then is the start of a vicious cycle – Japanese citizens saving, and pushing prices even lower and Japanese bonds even higher. In response, the Japanese government “tries” to tackle it by spending more, only to find that its huge bond market has been pushing the private sector’s bond market to the sidelines, because no business can compete with the safety inherent in a government bond. So prices keep falling, and investment inflows keep flowing to the government instead of business and the entire country becomes wrapped up in red tape. The cycle repeats; prices fall, bonds rise, and the Yen rises still more, and on and on and on again…
Investors challenge economist
Economists view Japan as an economic powerhouse in decline, and they stress rising energy costs alongside the government’s hesitancy to pass a bill which could restore the economic damage spawned from the tsunami. Economist also note that the Japanese government tends to have a somewhat laissez faire attitude as regards the global outlook for rising energy costs, which could have stemmed from their near total and long-term reliance on nuclear energy, and in the absence of that nuclear power, they have no clear policy direction. Add to that the sticky Yen factor and it all comes as a huge drag, pulling down the land of the rising sun. In fact, economists’ stridently argue that the government’s lack of a long-term strategic plan and the frozen political climate suggests that the chance for a positive change is slim and that Japan's ultimate decline will undoubtedly occur.
Investors, however, are starting to view things differently and increasingly diverging from the consensus economic view. They are becoming increasingly optimistic that the land of the rising sun will not just rise, but shine. When looking at the Nikkei 225, Japan’s premier index and ultimately the embodiment of investors’ sentiment, the picture is contrastingly bright. Since the global rally in equities started back in November, and through March 2012, the Nikkei outperformed most major indices including the S&P500, FTSE100, and even the Hang Seng, gaining a staggering 17.9% this year alone. It seems that while economists were busy debating how Japan could pull itself out of the muck and mud, the investment community has brushed off political worries and saw instead the enormous potential in the Japanese economy for growth and prosperity. Investors, in fact, are already witnessing a change.
Investors have pointed out some strong opportunities; first and foremost among them is the change to the Bank of Japan’s stance. While economists talk of the need for political change, investors point to the shift of the BoJ which set an inflation target of 1%.In point of fact, that means that the BoJ has become closer to the U.S. Federal Reserve in terms of monetary policy, by preparing to spur the economy with more asset purchases, partial money printing and easing credit until inflation returns. However, the setting of an inflation target could be considered a mere ploy which hides the BoJ’s real intent, i.e. to copy the Fed’s philosophy of printing money to spur growth. The “Bernanke cure” has, in fact, showed remarkable success considering that the U.S. has been able to stabilize growth after the apocalyptic credit crunch it experienced.
Investors see that as a major fundamental change; if inflation starts to emerge in Japan, encouraged by the BoJ, then the close to zero yields of JGBs will stop being attractive and Yen demand will eventually evaporate, and a weaker Yen can take Japanese growth a long long way. This process has already started and the Yen has now firmly stabilized above the 80 level; some earlier critics, including Goldman Sachs’ Jim O’Neil, who coined the term “BRICs,” is now predicting that the Yen Dollar rate is destined to reach 100, which will be exceedingly positive for Japan. Investors also point to Japanese corporations as attractive, valuation-wise, and which on the whole provide good long-term value; another way of saying, “we believe in Japan’s ability to recover.”
So, who is right, the pragmatic economists or the increasingly optimistic investors? That is yet to be seen, but what I can say with all confidence is this; when it comes to identifying opportunities, history has shown, time and again, that investors overwhelmingly have the upper hand.